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What do your stock, your Greek government bonds and your vacation home in Florida have in common? If you sell them and manage to make a profit, this profit will be taxed up to 43.4%.

In his widely praised book Capital in the 21st Century, Thomas Piketty proposes a top marginal tax rate of 80% for high income earners and a global progressive wealth tax of up to 2 percent for net assets above $5 million. Driven by the desire to tax the rich, manyothers turn to higher marginal rates as the answer. However, rather than just analyzing just the rates, it might be more fruitful look at the tax code and tax base. A good place to turn to is the individual capital gains tax.

Let’s start with three important statements on the capital gains tax from the IRS website.

1. Almost everything you own and use for personal purposes, pleasure or investment is a capital asset.

2. When you sell a capital asset, the difference between the amount you sell it for and your basis – which is usually what you paid for it – is a capital gain or a capital loss.

3. You must report all capital gains.

These capital gains, of course, are subject to taxation. Especially when it comes to stocks and bonds, the capital gains tax is seen as flawed; relatively high rates, numerous exceptions and othercomplicating factors. The current capital gains tax is complex and often favors economically similar investments differently. For example: short term capital gains (you decide to sell your Facebook stock within 1 year) can be taxed at the ordinary income tax rate of 39.6% (plus a 3.8% Obamacare surtax), whereas long term capital gains (you have faith in Mark Zuckerberg and keep your stock for longer than 1 year) can be taxed up to 20% (plus the 3.8% surtax).

These rates are amongst the highest in the world. The top marginal rate for long term gains in California is 33%, the third highest rate worldwide. Oddly enough, since we are taxing the capital gain and not the capital itself, we are taxing the people who are trying to get rich, instead of just taxing the rich people.

Photo credit: Codepinkalert

Richard Fuld probably did not pay any taxes on his Lehman Brothers stock in his last year as CEO. This brings us to another problem of the capital gains tax: the heavy volatility of revenue, which can be seen in the graphs below. Since capital gains are naturally connected to the economic cycle, capital gains tax revenue decreases drastically in times of recession and crisis, which is when governments usually spend more. It’s not a good idea for a tax base to have such a volatile boom and bust cyclical flaw.

Are there other ways of taxing capital gains? Indeed, in other countries such as the Netherlands, capital gains are taxed in a different way. Instead of taxing capital gains, taxable savings and Investments income is based on an assumed annual return on capital of 4%, which is the average return on state bonds, of net capital at the start of the year. This is taxed at a flat rate of 30%, making a flat tax of 1.2% (30% of 4%) on the taxable savings base. The tax has a personal exemption of around $29,000, which encourages low and middle income groups to save and invest their money.

There are several advantages to this system compared to the U.S. model in which only realized gains are taxed. Firstly, this system is relatively neutral when it comes to economic decisions: whether capital gains are long term or short term, realized or unrealized, the tax burden is always the same. It neither rewards risky investment nor discourages saving. This system is much easier to comply with for both taxpayers and tax administrators, which will cause a decrease in collection and filing costs, as well as the need for painful audits. Furthermore, since the tax is in its core a capital tax and not a capital gains tax, the revenue is less volatile.

Photo credit: Ahmad Nawawi

The current U.S. capital gains tax is rigged with exemptions, loopholes and preferences which makes it hard to formulate a revenue neutral alternative. For example, what would we do with currently exempt savings accounts such as traditional pensions, 401(k) plans, and IRAs?